FINFries | AFM | Chp 3 - 12 Part 2 | Decision Tree Analysis | Sriram Somayajula Sir

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In this FINFry we have explained Decision Tree Analysis:

Decision Tree Analysis
• Decision tree analysis involves depicting decision-making processes via a branching
tree-like structure, where choices and potential outcomes are evaluated
sequentially.
• Integral in capital budgeting, decision trees assist in assessing multiple scenarios,
weighing outcomes, and making rational investment decisions.
Structure of a Decision Tree:
At a decision node, a choice is made, leading to various possible outcomes represented at
chance nodes.
• Outcomes, such as good, bad, best case, worst case, or proceed and don't proceed,
reflect potential scenarios branching from decision points.
• The tree structure denotes a hierarchy where outcomes are evaluated
systematically, leading from right to left.
• The analysis begins by computing expected monetary value (NPV) at the end nodes,
moving backward to determine the most rational path.
• Rational decisions are made by choosing paths that maximize profits or minimize
costs, not driven by personal preferences.
Key Nodes and Components:
• Decision nodes: Points where choices are made regarding various alternatives.
• Events/ Chance nodes: Represent outcomes or events with associated probabilities.
• Outcomes: Depicted as circles, representing potential results of decisions and
events.
Application of Probabilities
Probabilities associated with chance nodes indicate the likelihood of specific outcomes,
providing a nuanced understanding of potential scenarios.
Decision-Making Process in Decision Trees
The evaluation starts from the right (decision nodes) and progresses leftwards, assessing
alternatives logically based on monetary implications.

Steps in Decision Tree Analysis:
• Define the investment problem.
• Identify alternatives for evaluation.
• Draw a decision tree.
• Evaluate alternatives using the decision tree structure.
• Make a rational decision based on maximizing profits or minimizing costs.

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